I never thought I’d see “Hayek” and “rap anthem” in the same sentence
For you Austrian rap music fans.
HT: Russ Roberts and Tyler Cowen. Russ did a superb job as producer. I’m starting to understand why Austrians think the boom is the real problem. I guess slow students like me absorb ideas better through music.
Update: I forget to mention that the filmmaker was John Papola
Tags:
25. January 2010 at 15:08
That is quite possibly the greatest thing in the history of mankind.
25. January 2010 at 15:33
My wife brought over her lap top and showed me this video.
I’m showing my students tomorrow!
By the way, if you believe Laubach and Williams, most of the drop in output is due to a decrease in productive capacity. (OK, I don’t believe them. Still, it is worth thinking about.)
25. January 2010 at 15:59
Thanks for posting a link to our video, Scott. I’m a fan of your blog though I continue to be confused about how NGDP and the mechanisms for manipulating it impact the microeconomic decision making process.
Here’s to a subtly more Austrian Scott Sumner via the persuasive power of Rap Music. It’s the BOOM that should make you feel leery, Scott! 😉
25. January 2010 at 17:33
Stiglitz said something at the 2010 AEA to the tune of, “What business ever cited low factor costs as the reason for its failure?”
How for the Austrians is it different with investors—who (they claim) begin to malinvest if the factor cost of investing (interest) falls? I understand they will begin to invest in increasingly marginal projects, but to say they will malinvest when given cheap capital is, I think, endangering the thesis of market efficiency that the Austrians sometimes rely on.
25. January 2010 at 18:11
Who has questioned that credit boom malinvestment and debt-funded consumption was a problem? The question is how best to address the debt overhang post facto. Liquidationism & bankruptcy, or inflation. Or, some combination…
The weakness of pop-Hayekians today is the assertion that the only way out requires a prolongued period of massive underutilization of resources. And the notion that a deflationary death spiral is self-correcting even in a complex, interdependent, highly specialized society where consumption is dependent on long term investment that is never made when there is no expectation of future demand.
And the weakness of those who claim the mantle of Keynes is their utter obsession with consumption instead of investment.
I still maintain that the problem is the investment/savings gap, NOT lack of AD. Your preferred approach is fix AD via monetary stimulus, then boost savings using policy, and investment will take care of itself. I would counter that this is not necessarily true in an open economy where capital flight (and carry trades) can take place, or if there are structural failures (e.g. corruption, severe agency problems, bad supreme court rulings, etc.) in the finance mechanisms. Domestic macro still hasn’t met up with international finance theory.
The main challenges to the inflation option are that _expectation_ of inflation/devaluation will scare away capital investment, and commodity prices will rise due to structural dependency on certain imports. Look back to FDR’s devaluation vs. gold events. They were enacted suddenly.
Look back to the long stretch prosperity post WWII – it was accompanied by massive long term investment subsidies (many of which were too massive, including the cost-plus regulation system for utilities, the double-taxation of dividends, etc).
These investment subsidies were replaced by the home mortgage interest deduction…
But even in the absence of pro-consumption policies, I am deeply skeptical that people (left to their own devices) save as much as they should in wealthy democratic countries. The cultural/behavioral/institutional factors all argue otherwise, and so does historical data.
The only benefit of depressions is that it restores behavioral propensity to save, and lowers consumption expectations – so maybe we do need a good long depression.
25. January 2010 at 18:58
inyourhouse, OK.
Bill, Sorry, I missed the Laubach and Williams piece you mentioned. BTW, I just saw the Atlantic will be in Charleston in October.
John, I didn’t know you read my blog. I just added your name to the post.
coray, I’ve always seen a conflict with Austrian econ and the EMH, which is why I can’t quite accept the ABCT. Still, there is much in Austrian econ that I like. Booms can lead to recessions, just not deep recessions.
Statsguy, You said;
“Look back to the long stretch prosperity post WWII – it was accompanied by massive long term investment subsidies (many of which were too massive, including the cost-plus regulation system for utilities, the double-taxation of dividends, etc).”
I can’t imagine how high taxes on capital are an investment subsidy.
You said;
“The only benefit of depressions is that it restores behavioral propensity to save, and lowers consumption expectations – so maybe we do need a good long depression.”
Please tell me you are kidding, and haven’t gone over to the dark side.
The question about culture and saving is an interesting one. My hunch is that culture is partly endogenous. When there are massive incentives not to save (as in our current economy) then the culture adapts to those incentives, it becomes a sort of cultural norm. In any case it is a moot point. Those disincentives to save aren’t going away, so I support forced saving whether the problem is governmental or cultural.
25. January 2010 at 21:03
Re double taxation of dividends: The argument was that a corporation had an incentive to reinvest in the company instead of releasing cash as dividends. The economic argument against it is clear as day – it caused overinvestment in a company even if there were few good investment opportunities; it was (supposedly) better for money to be returned to stockholders and invested elsewhere.
Assuming, of course, it was invested at all… And didn’t just sit in a cash account or get spent on a boat or dining out.
Overall, a terribly inefficient and punitive way of subsidizing fixed investment (or, more accurately, taxing consumption). So we ended it, and replaced it with what?
Same with cost-plus energy regulation, which was essentially a huge subsidy for fixed capital (over)investment. Very inefficient. Now, however, we clearly have underinvestment in fixed energy infrastructure.
Boosting savings does not automatically translate to lengthening the time horizon for investment activity. People just keep lots of short liquid assets sloshing around, particularly in an era of very high uncertainty – particularly when inflation & capacity utilization are so low that debt as % of GDP climbs (creating expectation of future monetization).
Even ZeroHedge – and if you think you’re a libertarian you have nothing on this guy – made an argument for a Tobin Tax recently to lengthen the time horizon for capital investment.
Re changing behaviors – news is depressing. Today Obama announced that we were freezing the ONE area of the federal budget that should be expanded – non-security discretionary (1/6th of total, the only part that has significantly shrunk in the past couple decades). But we’re keeping growth in transfers intact. And TSA, of course. And NSA. Yay. I think Jared Diamond was onto something when he argued that fallen civilizations chose to fail.
25. January 2010 at 21:25
coray, you’d have to read some Hayek or maybe some Roger Garrison to see how you’re missing some really key elements of the microeconomics. For example, you seem not to know anything of the elementary logic of choice of production processes across time.
In any case, most folks seem unaware of how Hayek grounds everything in a boom cycle pyramid of expanding leverage and credit — something Hayek believes is possible with no central bank intervention required. See Hayek’s _Monetary Theory and the Trade Cycle_.
coray wrote:
“How for the Austrians is it different with investors””who (they claim) begin to malinvest if the factor cost of investing (interest) falls? I understand they will begin to invest in increasingly marginal projects, but to say they will malinvest when given cheap capital is, I think, endangering the thesis of market efficiency that the Austrians sometimes rely on.”
And note well, what neoclassicals did with Hayek’s work on the communication and coordination function of relative prices is mostly a massive misunderstanding on the part of the neoclassicals — who, for example, typically learned their “Hayek” from Hayek’s (neoclassical socialist) student Abba Lerner and Lerner’s own students. The “thesis of market efficiency” isn’t Hayek — it’s what people who “didn’t get” Hayek invented as “Hayek” when they produced textbooks designed for teaching easy grading and mass undergraduate lecture halls.
25. January 2010 at 21:33
StatsGuy writes:
“Who has questioned that credit boom malinvestment and debt-funded consumption was a problem? The question is how best to address the debt overhang post facto. Liquidationism & bankruptcy, or inflation. Or, some combination”
Note well that Hayek endorsed both monetary and fiscal policy for partially counter-acting the post-boom “secondary deflation”. Hayek simply argued that an artificial leverage, credit, money expansion boom couldn’t be indefinitely sustained via every lower interest rates, an ever increasingly expanding money supply, ever increasing leverage and ever exponentially expanding government spending. And, likewise, monetary and fiscal policy could only partially counter-act the “secondary deflation”, and couldn’t prevent an inevitable structural re-ordering of the economy Arnold Kling calls “recalculation”.
Malinvestment = systematic structural disequilibrium in the economy across the time structure of relative prices and production processes, which means some production process will prove to be money losers within a re-ordered time structure.
25. January 2010 at 23:50
In defense of the Austrian position from this pop Austrian… I believe that the problems isn’t that entrepreneurs are dumb and squander cheaper investment funds. The Austrian position is that inflation-driven demand breaks the information mechanism of prices and profits. It tricks people into believing future demand will be higher than it actually is.
As the song goes, “the savings aren’t real, consumption is up too, and the grasping for resources reveals there’s too few”. Consumer behavior hasn’t changed. They haven’t reduced consumption to free up capital, labor and resources for investment. And so the economy “overheats” as many sectors are driven by inflation into over-investment whose debt load will prove unprofitable when the inflation is ended.
The turning point that reveals the malinvestments is the point at which the inflationary pressures drive up factor costs, busting budgets and drive up interest rates as credit demand catches up with credit supply.
Suddenly, that MGM Citywalk in Vegas doesn’t look like it will be profitable. That Brooklyn condo complex suddenly doesn’t appear at the new costs of production like it will be profitable. The real estate bubble seems to play out in exactly lockstep with the Austrian story. The post keynesian/minsky story seems to be compatible with the Austrian perspective as a way the boom gets magnified after it’s begun to take hold.
And so the upper turning point reveals that many investments were made based on false, inflationary demand and have become uneconomic goods.
I don’t believe that Hayek’s theory advocates deflation, since a deflation would have similar distortions to the relative prices that help investors determine consumer demand. Rothbard does, as he believes that a deflation will render capital goods profitable once again since their prices relative to consumer goods boom and bust more sharply (and the real balance effect will put a stop to people “hoarding” their money in fear). But Rothbard isn’t all Austrians. I prefer the White/Selgin/Horowitz/Garrison model.
At the heart of Hayek/Garrison is the theory of Capital as having a specific structure. All that “underutilized” or “slack” capacity in housing construction labor and equipment is now worthless. There’s no need for more houses and much of that capital is specific in it use.
I’m starting to ramble. Anyway, Hayek’s story is far richer than “let deflation cure it”. I believe the question we need to consider is at what level our aggregation masks the things that really matter. Capital isn’t “K”. The “underutilized resources” may indeed be worthless, or “uneconomic goods”. If my GM volt factory is built to spit out a car that nobody wants… the sooner we liquidate that factory and find a better use for those resources the better.
Anyway, thanks for watching the video. I’m not an economist, I just play one on TV.
26. January 2010 at 04:40
Scott,
I’m glad to hear the story is beginning to make some sense to you! I now realize I should’ve been rapping instead of arguing with you about the expansion of the money supply in the 1920’s having anything to do with the 1929 crash!
Coray,
The point is that the manipulation of interest rate does not “really” make capital cheaper; it makes it appear cheaper. The only thing that could make capital cheaper is increased savings. Without increased saving, artificially lowering the price of capital will lead to people “buying” more capital, when that capital does not exist. Think of this as “overconsumption” of capital, by investing it in unproductive enterprises. Notice that the price is artificially lowered, but the real quantity of real savings has NOT increased. And that’s precisely the problem. People think capital is cheaper, and more plentiful. In reality, it is dearer. But they act as if it is cheap. You can see the problem here, can’t you? Imagine if we’re running out of oil, but the government decides to drop its price to make it more available: not only will we still be running out of oil, we will run out of it faster! Once reality catches up, we’re in deep trouble.
The distortion of the price makes it appear that there is more capital out there than there really is. People undertake too many unproductive projects for which there isn’t enough capital to completion.
So long as the price of capital is artificially lowered, people will continue in these unproductive enterprises. As soon as the artificial lowering stops, these malinvestments are exposed for the white elephants they are and go bankrupt. The price of capital is adjusted upwards drastically, and the bad projects can no longer afford the new capital needed. This leads to a systemic cluster of bankruptcies across the economy: a recession. The only reason you ever get a systemic cluster of error is through manipulation of the money and credit supply””which is the coordination mechanism of an economy. Otherwise, you can’t get systemic errors. That’s why every big recession is preceded by artificial lowering of the price of credit.
Finally, Austrians categorically do not rely or believe in the efficient market hypothesis. In fact, they reject it. See the work of Israel Kirzner on entrepreneurship for more on this.
26. January 2010 at 09:12
Greg, I agree. Really.
John Papola:
“so the economy “overheats” as many sectors are driven by inflation into over-investment”
Mal-investment, certainly. But over-investment? Really? Let’s consider… Let’s start from the observation that the savings rate has gone up since the crisis began, which is a good thing. Why, then, such low utilization rates?
1) We’re investing too much… (really?)
2) We’re consuming too little… (really?)
3) We’re working too much, and we really needed this vacation (hmmm…)
Let’s discount #3 – most unemployed folks want jobs. Let’s discount #2 – we’re still borrowing from abroad to maintain consumption. That means #1. Your response to this seems to be:
“All that “underutilized” or “slack” capacity in housing construction labor and equipment is now worthless.”
Worthless is a very strong word. Perhaps you meant “worth less”, since it’s a fairly strong argument to claim that all of the resources dedicated to housing construction are completely infungible. It seems that investments could be redirected at lower prices, which is a problem when both human and physical capital were purchased with nominal debt. It’s a bigger problem when redirection would require long term investments in an economy with huge uncertainty about future demand.
The thing is, I think people (finally) get that their houses and shopping centers are worth less than the market said they were worth 3 years ago, and their response is (rationally) to save more. Good.
At a national level, the response _ought_ to be to invest more in new sectors that are productive. Confronted with a massive savings increase resulting from the realization that past investments were non-productive, we should be _massively increasing_ investment in _something_. Instead, the economy has done the reverse.
The Kling explanation is a recalculation – the economy is still trying to “figure out” where to deploy investments, so in the meantime it’s holding a lot of “liquidity”. At the national level, resource liquidity means unemployed labor/capital (literally). I suppose a Depression is simply ‘decision paralysis’; the economic equivalent of political gridlock.
My concern with pop-Austrians (vs. real Austrians) is exactly the distinction between Selgin & others – how to handle the hangover. In your video, you compare inflation withdrawal to alchohol withdrawal. How very appropriate. Without medical treatment, the death rate from delirium tremens is up to 35%. With treatment, it’s as low as 5%.
“Hayek’s story is far richer than “let deflation cure it”.
I’m not arguing against Hayeck. I’m arguing against pop-Hayeck. I’m not sure I fully grasp rap-Hayeck yet. Real Hayeckians may yet save the economy, if the pop-Hayeckians don’t liquidate it to death.
26. January 2010 at 09:21
Regarding uncertainty suppressing long term investment – there are really two types of uncertainty. Technical uncertainty (are thorium reactos better than solar farms?). And socially constructed uncertainty, resulting from the type of Nash equillibrium behavior that Nick Rowe describes.
26. January 2010 at 10:24
For the next rap, I vote for Krugman and Sumner.
26. January 2010 at 13:16
“understand they will begin to invest in increasingly marginal projects, but to say they will malinvest when given cheap capital is, I think, endangering the thesis of market efficiency that the Austrians sometimes rely on.”
Market efficiency — that would be neoclassicals, not Austrians.
Malinvestment: it’s a prisoner’s dillemma. See carilli and Dempster.
26. January 2010 at 13:21
“he Austrian position is that inflation-driven demand breaks the information mechanism of prices and profits. It tricks people into believing future demand will be higher than it actually is.”
John, that explanation doesn’t work — it falls to the criticism by Yeager and others that asks “How could they keep getting fooled each time?” The right explanation is the one I link to above. Roger Garrison and I apply it in some detail to an actual boom and bust here.
26. January 2010 at 13:56
StatsGuy, you clearly have a lot to learn about Austrian economics. It’s ok, though–we all have to start somewhere.
May I suggest that you (and anyone else who’s interested) start with this excellent presentation by Roger Garrison? It addresses your concerns regarding over-investment, over-consumption, and malinvestment. While it doesn’t offer any solutions to the depression, I promise you won’t be disappointed.
http://www.youtube.com/watch?v=zhoFOyy7rbo
If you want to read a popular explanation of the Austrian prescription, read this Bob Murphy article:
http://mises.org/daily/3155
26. January 2010 at 16:49
Statsguy, You and Diamond are way too pessimistic, we’ve been through far worse, and always bounce back.
I can’t tell if you favor or oppose the double (actually triple) taxation of dividends.
John, A couple points:
Even some of the Austrians you mention favor mild deflation.
You make a good point about both saving and consumption rising during a boom. Of course this implies national income and output also rise. But here’s what I take away from that fact; C and I aren’t the key prioblem, rather in a boom people are working too hard, producing too much total output. That’s what needs to be corrected.
The reason booms don’t “feel bad” even though they are inefficient, is because society is full of distortions that discourage output, so the boom may actually move you toward the more optimal output. But even if it does (as in Europe, where employment is usually too low) it isn’t sustainable, and thus leads to a downturn.
saifedean, Yes, you just didn’t speak my language.
statsguy, What I don’t get is why there wasn’t a depression between mid2006 and Mid2008–that ‘s when housing starts fell from 2.1 million to less than one million. But total GDP went up over that two year period. The recalculation people don’t seem to have an explanation. The timing is all wrong. Where were those unemployed construction workers going?
anon, That would be painful to watch.
Gene, I’ll try to read those later, I am way behind. But I think I do understand your point. As a pragmatist I can understand the appeal of a “third way” model that rejects liberal dogma that market failure requires government intervention, and conservative dogma that markets are always efficient. Of course I’m oversimplifying everyone’s views here, but I think I do understand the appeal of Austrian theory.
Ash, No disrespect, I know your comment was directed at Statsguy. But people are always telling me that I don’t understand Austrian views, and I must read such and such. One example was a slide show by Garrison. But when I watched it, it seemed exactly like I expected, based on my superficial reading of bits and pieces of Austrian economics. I don’t find it as mysterious as it is sometimes made out to be.
26. January 2010 at 16:55
Gene, Just looking at the abstract of that paper, the prisoner’s dilemma angle is interesting. I’ve always thought that the business cycle is too big a mystery to be explained by a single attribute of the economy. I focus on nominal wage stickiness even while understanding that other issues like real wage stickiness, price stickiness, misperceptions, etc, etc, all may play a role in this complex phenomenon. And perhaps the prisoner dilemma also plays a role. A few weeks ago I pointed out that workers often can’t save their jobs with wage cuts, unless all workers in the economy simultaneously agree to wage cut. That thought experiment sounds a bit like the prisoner’s dilemma. I gather the paper you link to applies this idea to the credit markets.
26. January 2010 at 17:04
Scott,
Your mentioning this is surprisingly apt for something happening at my university. The administration intends to lay off a bunch of staff — and the staff fought back a few months ago by suggesting a collective agreement that they would accept equal pay cuts for all if they could keep their jobs in return. Yesterday I submitted a column to one of the university student papers suggesting that this was a prisoner’s dilemma which could be solved if some collective bargaining process took place, binding each employee to accepting the wage cut, and binding the administration not to lay off any further employees. I don’t have any real insight to add, except that what you mention closely parallels the thoughts I had about the retrenchment issue at my university.
26. January 2010 at 17:17
Ash, thank you – I had forgotten just how snarky Bob Murphy can be.
Murphy’s sushi economy example is cute, but it leaves this little thing called money. Remember, in a barter economy, liquidity traps don’t exist. Liquidity doesn’t exist. It’s odd that Murphy leaves out money, since credit cycles are key to Hayeck’s work.
But, as with ssumner, I don’t see anything in there that is inconsistent with my understanding of ABCT. Nor anything that refutes the notion that reallocation/rebuilding of capital should be accelerated by keeping the economy out of a demand/investment trap.
Remember this fundamental data point: In Murphy’s story, when they realized they were poorer, the overall decrease in activity was accompanied by a sharp increase in activity in productive sectors. But back in Oct 08, we saw across the board falls (or, at best, flat trends) in pretty much all sectors and professions.
And, that was WITH monetary stimulus.
Murphy snarkily complains that Krugman and Cowen only tell partial stories, but his is the most partial of all. In both senses of the word.
That’s the difference between pop-Hayeckians and real Hayeckians.
26. January 2010 at 17:19
By “with monetary stimulus”, I mean with paltry and inadequate monetary stimulus.
26. January 2010 at 19:24
ssumner –
– I oppose double taxation of dividends, since there are far more efficient ways to encourage long term investment. Same with cost plus regulation. Sadly, we have disavowed those other methods, instead deploying mortgage deductions as our mechanism of “saving”.
– Why didn’t we crash in 2006/2007? Well, two major reasons. 1) we believed in global decoupling (aka, China/EU would trounce the US) and contagion containment. (Did I ever link the IMF contagion charts?) 2) we believed in Bernanke, and his ability to manage. The single strongest retort to the very dire predictions of collapse in 2007 was “Bernanke would never allow that, he’s a student of the great depression.” Then he did.
Also, in 2007, Bernanke was giving speeches like this:
http://www.federalreserve.gov/newsevents/speech/bernanke20070831a.htm
“Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past.9 These results are embodied in the Federal Reserve’s large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model’s estimate of 25 percent or so under what I have called the New Deal system.”
In other words, the deep liquid securitization markets and sophisticated risk management had helped decouple residential investment and monetary policy. (oops)
Securitization wrought its own demise by coupling everything that was decoupled. In terms of how ideas feed back into the system, consider the following: prior to 1990, many assets moved relatively independently (or were even negatively correlated). Financial engineers figured out that they could use assets with inverse correlations to reduce risk by bundling them together. (Reduced risk meant you could lever up more.) What happened?
The correlation arbitrage caused asset classes to become more correlated… This effect got even worse since 1990.
http://static.seekingalpha.com/uploads/2008/7/22/saupload_correlation721.png
Today – http://www.assetcorrelation.com/user/correlations/90
The massively interdendent “deep and liquid” securitization markets linked everything together, so that assets that were thought to be orthogonal were in fact linked, often through long contract chains. And everything was negatively correlated to the US dollar. Then a carry trade built against the dollar (led by commodities) as investors bet the Fed would need to devalue/reflate. The Fed, however, decided to prove them all wrong. And it did.
27. January 2010 at 08:18
It’s fascinating that you leave out the causal mechanics of the engine of the economy — the structure of production. And you leave out the most powerful price coordination mechanisms ruling over this engine — leverage, profits, interest rates and credit.
These core and elephantine workhorses of the economy are ignored in favor of what is easiest to imagine as a “given” in a math construct — aggregate labor prices.
It’s as if the fallacy of the seen and the unseen has been imported into the heart of macro …
Scott writes:
“I’ve always thought that the business cycle is too big a mystery to be explained by a single attribute of the economy. I focus on nominal wage stickiness even while understanding that other issues like real wage stickiness, price stickiness, misperceptions, etc, etc, all may play a role in this complex phenomenon.”
27. January 2010 at 09:58
Just to point out in clear terms, the video agrees with your description of symptoms, just not your prescription: the grasping for resources reveals there’s too few. (4:45-4:50)
In other words, monetary policy was really loose until it was really tight.
So the Hayekians (pop, real, snarky, trolling, or any other brand) ought to agree with your story that monetary policy was tight, even though they disagree with your proposed solution. Had the Fed loosened policy further in 2008, it wouldn’t have prevented anything, just prolonged the bubble, making way for a bigger bust.
The thing that I don’t see in the data for their story is a run up of inflation. I’ve never been able to take a steady, reliable 2% inflation rate and see a serious inflation throwing all price signals out of whack; top that with lowered inflation expectations you blog about at the time of the crash for a nice little cherry. I also don’t see the massive factor price adjustments in late 2008 that would have to be there. Does anyone else see it in the data? The only thing we see from the financial and monetary stimuli so far overshoots the government’s worst case scenario without stimulus (ala Mankiw’s plot).
27. January 2010 at 10:31
A couple over-analyzed-analogy comments:
Bartenders are enablers, but they don’t force anyone to drink. Their job is to meet the volume of drink requests with sufficient alcohol. They don’t pour a row of shots and see who buys them, and the more they pour, the drunker they make everyone else. Getting drunk is largely demand driven.
Though I am a confirmed teetotaler, even I agree that most people don’t go crazy over a beer after work. In order to believe that steady 2% inflation (or even decreasing inflation) is a massive monetary stimulus that will give everyone a hangover, akin to the colorful bacchanalian festival in the film, you have to believe some pretty interesting things about how the body processes alcohol.
27. January 2010 at 12:56
@statsguy: I agree the problem is low savings.
@D. Watson
“The thing that I don’t see in the data for their story is a run up of inflation. I’ve never been able to take a steady, reliable 2% inflation rate and see a serious inflation throwing all price signals out of whack; top that with lowered inflation expectations you blog about at the time of the crash for a nice little cherry. ”
A better way to think of it is not the run up in inflation, but the mis-alignment of savings and borrowing. If high growth is being financed out of high aggregate borrowing coming from high aggregate savings rate, then you don’t necessarily get a big bust. If the high growth is being financed out of borrowing that is financed from money creation, four things happen (and do usually).
1) It is paid off with the creation of new wealth
2) It is paid off with the devaluation of real assets (like houses)
3) It is paid off with the devaluation of real assets (like debt, and money)
4) If its paid off by creation of new debt
(1) always happens on its own, (2) is what deflationists like Rothbard maximize. (3) is what monetarists to maximize, (4) Keynesians end up doing this, by using government debt.
The dilemma
Choosing (1) is very slow, so for the short term the others still come into play
Choosing (2) is extremely painful in the short term, and causes large amounts of instability and political harm.
Choosing (3) delays the problem and continues lowering savings
Choosing (4) ends up levering up more debt
As a side note: does anyone know is they count insurance as savings or as consumption in the US?
27. January 2010 at 14:19
johnleemk, Thanks, but workers in cyclical industries can only keep their jobs if the entire economy agrees to wage cuts. I believe that some small countries like Austria do have economy-wide pay agreements, but it wouldn’t work in a big economy like ours.
Statsguy, Those are good points. Assets that may be uncorrelated in response to certain types of shocks, suddenly look highly correlated when there are big changes in NGDP.
Greg, I agree that profits are the engine. But because wages are sticky, when NGDP rises unexpectedly, profits soar, and this drives output much higher.
D. Watson. You sadi;
“So the Hayekians (pop, real, snarky, trolling, or any other brand) ought to agree with your story that monetary policy was tight, even though they disagree with your proposed solution. Had the Fed loosened policy further in 2008, it wouldn’t have prevented anything, just prolonged the bubble, making way for a bigger bust.”
I can’t wait to see the mother of all bubbles burst in Australia. They have a lot of bad karma by now, not letting NGDP fall since 1991.
I agree with you, I just don’t understand how mild, predictable, inflation would be such a problem. Good drinking analogy.
Doc, I presume the output of the insurance industry is consumption, but the gross payments involve lots of saving as well.
27. January 2010 at 15:57
Gene,
I’ll read your paper on the dotcom bubble. I’m also currently reading Roger’s Time and Money, which is awesome. I put 5 stages in the hayekian triangles in our video as a nod to Roger.
Scott,
Here’s what I’m trying to understand from your point of view, which I know has strong overlap with Selgin and even Hayek. I’m not even quite sure how to format this question, so I’ll list my mental steps:
#1. So the Fed observes a drop in NGDP from the BLS data (monthly right?)
#2. They don’t know if it’s a drop in M or V (or P or Q, right?).
#3. They don’t know the reason why this is happening exactly. I’m not sure if there’s any mechanism for understanding the causal relationship. Are people freaked out because they see the housing market shrinking and unemployment on the rise?
#4. The Fed tries to stabilize NGDP (or, I guess, the NGDP growth rate) by buying stuff to get more money in people’s hands for them to spend.
#5. The restoration of expected nominal spending prevents a downward spiral.
But…
Which people get the money? Aren’t there distributional effects in the way in which the money enters the economy (cantillon)? What if the reasons for the decrease in spending, which is certainly not uniform but sectoral, lead people to continue holding the money? Or what if the banking system holds the reserves? If the Fed turns to buying other stuff in the open market, aren’t those distributional effects even more pronounced?
My inclination in the NGDP-targeting under central banking story is that it’s a second-best solution that will still suffer from the same knowledge problems any central planner faces. I suppose that’s where your futures contracts come in, right?
I understand what the accounting entity MV = PQ is meant to, well, account for. But there is this structure of production question that seems to have real merit in Hayek and appear absent in every non-austrian story. It’s not just about more spending or expectation of spending. It’s about more spending ON WHAT and expectations ABOUT WHAT?
I’m not sure if I’m even asking these questions in a way that makes sense. Money and Macro are hard, but I’m trying. Hey, at least I don’t curse fractional reserves 😉
27. January 2010 at 20:18
coray writes:
“How for the Austrians is it different with investors””who (they claim) begin to malinvest if the factor cost of investing (interest) falls? I understand they will begin to invest in increasingly marginal projects, but to say they will malinvest when given cheap capital is, I think, endangering the thesis of market efficiency that the Austrians sometimes rely on.”
Contrary to Stigler, malinvestments have nothing to do with “lower factor costs.” They have everything to do with interest rates that are below the natural rate of interest (which is determined by the supply and demand for investible resources). Investors decide to invest based on whether projected cash flows top the hurdle rates they use. The former are calculated using discount rates that will generally be too low if prevailing interest rates fall below the natural rate. This will overvalue expected returns; this process will be reversed when rates rise (and of course the natural rate can fall, speeding this process).
27. January 2010 at 21:30
Scott, I said production well coordinated across time is the engine. Profits are one of the signals that sometimes acts to coordinate production across time — and under some conditions does NOT coordinate production across time.
Soaring profits and higher output in non-sustainable production process are often attributes of an artificial and unsustainable mal-coordination of the economy.
An I note you are ALWAYS thinking in unreal aggregates, i.e. the “wages” aggregate, and the “profit” aggregate, and the “output” aggregate.
Whose wages are sticky — not all of them. Labor is heterogeneous and wages are heterogeneous. In the higher reaches and the most specialized niches wages are highly variable. Government wages _are_ sticky. Professor wages are sticky. And union wages are sticky. And minimum wages are sticky.
Most of the people I know do _not_ have “sticky” wages.
And “output” varies industry to industry, country to country, state to state, and company to company.
“Output” isn’t an “aggregate”.
Scott wrote:
“Greg, I agree that profits are the engine. But because wages are sticky, when NGDP rises unexpectedly, profits soar, and this drives output much higher.”
28. January 2010 at 08:49
Greg,
“Most of the people I know do _not_ have “sticky” wages.”
It’s all a question of how sticky and in which direction.
The stickiness examples you point out are highly sticky. My wage is set by contract and it won’t be time to renegotiate that contract for almost two years, so I think it’s pretty sticky. It would take a lot of inflation or a lot more recession to get either party to broach the subject.
As a thought experiment, if the prices of everything but wages were suddenly overnight increased by 20% one time, how many of the people you know would be able to have negotiated a similar increase in their wages within the day? 1 week? 2 weeks? 1 month? Then there’s the time to get the paperwork done and submitted through an HR that suddenly has a lot more work to do, and another pay period goes by before it’s in the system…. I think it would take some time before a majority got their wage adjusted, let alone everyone. Not years, but some economically relevant time. At the very least, there are incentives for managers to drag their feet a little bit because they’re earning “exploitation profits” until the adjustment happens and the time it takes to find a new job with another manager willing to adjust faster takes time and productive resources.
And that’s wages going up. There’s plenty of behavioral evidence that wages are stickier going down than they are going up. Going down there are layoffs involved too, and that takes months to adjust.
28. January 2010 at 10:07
Ok, I think I’m starting to get what everyone is talking about.
Statsguy:
Bob’s analogy was based on pure capital theory, that is, capital in world with no money. Hayek wrote a neat little book on the subject. The point of Bob’s article was to show how even if you remove all the money in an economy, and you can actually see which resources are being inefficiently allocated, you still require some resources to be ‘under employed’, until everything gets back to normal.
Now, when you introduce money, things get much more complicated. It’s become more difficult to directly see where and which resources are allocated inefficiently, thus you must let prices re-adjust. What happened during the boom was that prices were bid up artificially, especially in interest-sensitive sectors, thus after bust, investments were shown to have been badly made. But these high prices in the investment sectors weren’t isolated–they leaked to other sectors too. Thus, all sectors that were exposed to sectors with malinvestment, either directly or indirectly, will liquidate to see how exposed they were.
Scott (and other people),
The problem isn’t exactly an increase in the money supply–it’s an increase in credit, which eventually leads to an increase in money supply.
Peter Schiff’s drinking analogy is not bartenders at a bar: it’s chaperons at a high school prom spiking the punch bowl. Thus the teenagers don’t know what they’re drinking, so who are you going to place the responsibility on?
28. January 2010 at 14:12
@Ash:
“The problem isn’t exactly an increase in the money supply-it’s an increase in credit, which eventually leads to an increase in money supply.”
If the increase in credit is caused by increases in savings elsewhere in the economy, its not really a problem. If the credit supply increases without increased savings, then it will lead to problems.
@
“I can’t wait to see the mother of all bubbles burst in Australia. They have a lot of bad karma by now, not letting NGDP fall since 1991.”
For Aus, it isn’t as bad, because this whole time, they have ben reducing their net public debt. And what really matters for ABCT is debt and savings. Also, they are heavily reliant on resource extraction (which is volatile), and China, so yes I think they are due for a recession.
28. January 2010 at 14:13
That last @ was for Scott.
29. January 2010 at 06:12
John, You asked:
“#1. So the Fed observes a drop in NGDP from the BLS data (monthly right?)
#2. They don’t know if it’s a drop in M or V (or P or Q, right?).
#3. They don’t know the reason why this is happening exactly. I’m not sure if there’s any mechanism for understanding the causal relationship. Are people freaked out because they see the housing market shrinking and unemployment on the rise?
#4. The Fed tries to stabilize NGDP (or, I guess, the NGDP growth rate) by buying stuff to get more money in people’s hands for them to spend.
#5. The restoration of expected nominal spending prevents a downward spiral.”
1. No, they should target expected future NGDP.
2. If it is past data (as in question 1) they know precisely how much of the decline was due to lower velocity. They have money supply data, and thus can infer velocity from NGDP.
3. I agree.
4. Yes.
5. Yes.
Distributional effects are trivial for several reasons.
1. The monetary base is a tiny share of wealth.
2. Open markets operations swap cash for T-bills. Nobody is richer.
3. The same effect comes from monetary policies that lower reserve requirements, and these don’t inject ANY new money into the economy.
A common mistake my readers make is to assume that new money can go into housing, or into stocks. In fact money doesn’t enter or exit markets. There is no building on Wall Street containing all the money people put “into” the stock market. Money is merely a medium of exchange.
Monetary disequilibrium is a problem that has been around forever, in all kinds of systems. You are right to be skeptical of central planners. But the solution is not to go back to an automatic system like the gold standard, as those were also very unstable. Rather the solution is to go forward to the next step beyond central planning, letting the market determine the money supply in such a way as to stabilize NGDP. I believe that if Hayek were alive he would favor this system.
The analogy I would use is the command and control system of controlling pollution. The solution was not to go backwards to no limits on air pollution, but to go forward to tradeable pollution permits. And we did. And it worked better.
Bill, But recall that back in 2002 and 2003 interest rates were not below their natural rate, the demand for credit was very low.
Greg; You said;
“Most of the people I know do _not_ have “sticky” wages.”
So the only people you know are Mexican day laborers who wait at street corners for jobs? If you are paid by the hour, then unless your hourly wage rate changes each day, you have sticky wages.
If there are no such things as aggregates then there are no such things as inflation, recessions, booms, depressions, as all those terms are defined in terms of aggregates, and also calculated that way.
Ash, You said;
“The problem isn’t exactly an increase in the money supply-it’s an increase in credit, which eventually leads to an increase in money supply.”
I disagree. Credit doesn’t matter. Money is the key factor driving the business cycle.
Doc Merlin, You said;
“For Aus, it isn’t as bad, because this whole time, they have ben reducing their net public debt. And what really matters for ABCT is debt and savings.”
I thought the Austrians worried about private debts too. They have run massive current account deficits for decades. Bigger than the US.
If commodities are the key, why didn’t they have a depression when commodity prices crashed in late 2008?
29. January 2010 at 13:42
Doc:
Of course, I meant an artificial increase in credit (i.e. without an increase in real savings).
Scott, you said:
“Credit doesn’t matter. Money is the key factor driving the business cycle.”
So, if the USG decides that the Fed will have to stop lending to banks, and its only function would be to pay government employees’ salaries, that will cause a business cycle?
I beg to differ. I (and other Austrians) maintain that only when new money is lent into existence does it cause problems. Because what does a loan signify? That real capital exists and when it is lent, it must be paid returned. But when a central bank creates credit out of nothing, and the banks lend out this new credit-for-nothing for something, how can anyone expect businesses to make long-term profitable investments?
Imagine it like this: One day you call up a friend and say, “Hey, this is going to sound weird, but you’re my last option. I’m starting a new plumbing business. I’m going to call it ‘Sumner’s Liquidity Trap Solutions’; I’m thinking of having as my logo a picture of Krugman in a toilet. Anyway, I need to borrow a truck to get started. Everyone else I know either doesn’t have one or won’t lend one to me. Can you help me out?”
“While the interest I have in your plumbing company is already at the zero-bound, I totally have a truck you can borrow. Everyone has at least two trucks here in Tennessee,” replies a snarky Bob Murphy.
Excited, you then go out and buy all your equipment on credit. You then take out an ad in the paper, and after a while, you get an order. Life is good!
Your supplies have arrived and they are on your driveway. Your customer is waiting for you. You then call up Bob and ask him for the truck. But wait–it turns out he thought you, being an academic economist, were being facetious when you said you wanted to start a plumbing business; so he was only being sarcastic when he said that he actually had a truck to lend to you. Uh oh.
Now you’re in trouble. Without a truck, you can’t haul all your equipment or go to the customer’s house. You have to call your customer to cancel your visit. Your creditors want their money. Since your suppliers have a no-refund policy, so not only will you have to sell the equipment you’ve bought to someone else, but if you can’t make up for everthing you’ve lost, you must sell some more of your personal things to get even. So because of Bob Murphy, you are now worse off than before.
But imagine if Bob Murphy was a magic man who could create trucks out of nothing on demand, and give them to anyone who wanted them, and expected nothing in return; then would we see a business cycle? I contend that No, we would only see an increase in the number of trucks, which would bring down the price of trucks. Which, if it continued for a while, would eventually lead the price of trucks to zero.
So the case has been made that only an increase in credit can lead to the business cycle. A mere increases in the money supply only leads to price inflation. Increases in credit (without an increase in savings) will lead to a business cycle.
30. January 2010 at 21:58
@Re: Ash
🙂
Good, glad we are on the same page here!
I agree, also with your example of the trucks, although there would be some
RBC/recalculation effects of Bob Murphy being a magic truck man. Unemployment would rise temporarily and overall we would be a lot wealthier, truck companies would suffer serious problems, thus hurting their creditors and so on down the line, until the economy had finished re-calculating the effect of the shock.
30. January 2010 at 22:02
“If commodities are the key, why didn’t they have a depression when commodity prices crashed in late 2008?”
because
1) the savings was high enough to tide them over, after years of profits.
2) They still had a lot of iron ore contracts
As I have said earlier, it is not debt that is a problem, Scott, its debt to savings and Australia has had a very high savings rate for a number of years.
31. January 2010 at 07:38
Ash, You said;
“A mere increases in the money supply only leads to price inflation.”
In my view the higher prices is what causes cycles. More money raises prices and especially NGDP. Because nominal wages are sticky, companies respond to the higher nominal demand by raising output.
I see credit as endogenous. When more money raises NGDP and creates a boom, credit tends to follow along as there seem to be more profit opportunities.
Doc merlin, You said;
“If commodities are the key, why didn’t they have a depression when commodity prices crashed in late 2008?”
because
1) the savings was high enough to tide them over, after years of profits.
2) They still had a lot of iron ore contracts
As I have said earlier, it is not debt that is a problem, Scott, its debt to savings and Australia has had a very high savings rate for a number of years.”
I don’t think they are high savers, they consistently have one of the world’s biggest CA deficits. On the other hand the US had big budget and trade surpluses on the eve of the Great Depression. Savings doesn’t prevent recessions.
Furthermore, even if they had ore contracts, falling commodity prices should have reduced expectations, and thus investment in new mining projects.
They also missed the 2001-02 recession, but world commodity prices were not high at that time. Demand-side recessions are not inevitable, they are caused by tight money.
31. January 2010 at 09:57
Scott, if high prices are what lead to business cycles, then are third world countries with consistent double digit inflation in a perpetual business cycle?
If you say No, it’s only a relative increase in the money supply, then tell me this: if the government only printed money to pay government employees’ salaries, will that lead to a business cycle?
I maintain that the distribution will be totally random, and thus we will not see systematic reallocation of resources, systematic misallocation of resources, followed by a systematic correction in the allocation of resources.
1. February 2010 at 06:38
Ash, With LDCs there are two issues.
1. The trend rate of inflation is often higher, which is why it is the unexpected part of inflation that matters.
2. And they are far more susceptible to supply shocks than we are, hence they often have rising prices in recessions. That’s why I prefer NGDP for the US, and not inflation. NGDP is a purer indication of when AD is excessive. Prices can rise for many reasons.
Anything that causes the money supply to go up unexpectedly, no matter how the money is distributed, can cause unexpected inflation. And if wages are sticky then unexpected inflation will have real effects on output.
2. February 2010 at 10:01
Ok Scott, I think this is as far as we can go for now. I’m optimistic though. After only a year of blogging, you’ve started coming around as to seeing how the boom is the problem in business cycles. I predict a year from now you’ll be beginning to see how credit expansion (not necessarily monetary expansion) is the cause of that boom.
Maybe it’ll take a Mises vs. Friedman opera battle.
2. February 2010 at 19:06
To understand the Austrian theory of the trade cycle, one has to understand Austrian capital theory and the Wicksellian framework. For Austrians, capital is extremely heterogeneous and complimentary. This means that, the marginal productivity of capital not only depends on the actual capital good itself, but on the remoteness of its employment. The interest rate must assure that capital flows into the most capable hands (highest rate of return). When it’s artificially suppressed, then it sends incorrect information signals to entrepreneurs who take scarce resources away from those who intend to use it for warranted productions. Of course, this means that Say’s law remains valid, that is, that scarcity exists.
Those who are entirely unfamiliar with the time preference theory of interest, can never understand Wicksell, and the Austrian business cycle theory.
3. February 2010 at 14:36
Ash, I’d rather say “instability is the problem.” Whenever you have instability, it is a given that you will have both booms and recessions. So in that sense I am more Austrian than Keynesian. Keynes wanted to shoot for boom conditions 100% of the time. But I wouldn’t single out booms, it is the instability that matters. The current severe recession was not caused by a major boom in 2006, indeed the 2006 boom was much smaller than the 2000 boom.
Esuric, I think I understand the time preference theory of interest